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An Introduction to Master Limited Partnerships

Key Points

Master limited partnerships are a type of investment that can offer investors relatively high yields.

Those high yields are accompanied by other unique characteristics, like complex tax consequences and sector concentration.

Master limited partnerships should not be considered bond substitutes.

Master limited partnerships, or MLPs for short, are investments that can offer investors high yields. The high yields may seem appealing, but there are a handful of other characteristics—and risks—that investors need to be aware of before making an investing decision.

What are master limited partnerships?

Master limited partnerships are just that—partnerships. Most MLPs have one general partner and many limited partners. The general partner usually covers the managerial and administrative aspects of the MLP and is controlled by the corporation that contributed the assets.1

Most MLP investors are limited partners. Limited partners provide capital, and in effect, own units of the MLP. By providing capital to the MLP, the unitholders are then entitled to periodic income distributions from that master limited partnership.

According to the Securities and Exchange Commission (SEC), master limited partnerships are “exchange-traded investments that are focused on exploration, development, mining, processing, or transportation of minerals or natural resources,” and they often hold cash-generating assets such as oil and gas properties or pipelines.” 2

Master limited partnerships are considered a type of pass-through entity. A pass-through entity is a business structured so that it is not subject to income tax—but the distributions to MLP unitholders are generally subject to income taxes. A key benefit of the partnership structure is that the income distributions are not taxed twice the way the dividends of a common stock are taxed. (A traditional corporation’s income is generally taxed first, and then shareholders are taxed on the dividends received.) And because MLPs trade on national exchanges, they offer greater liquidity than traditional partnerships.

High yields come with complex tax consequences

An MLP is a pass-through entity which in general pays no tax itself. Just like a partnership, it is treated by the tax code not as a separate taxable entity, but as a collection of partners, so taxes are typically paid by the partners/unitholders rather than by the business. That allows investors to be rewarded with relatively high distribution payments.

Historically, MLP distribution yields have been well above those offered by most stocks in the S&P 500® index. As the chart below illustrates, the average yield of the Alerian MLP Index was 8.1% at the end of April 2018, compared with a dividend yield of just 2.0% for the S&P 500.

MLPs offer higher yields than the broad stock market

Source: Bloomberg. Trailing 12-month distribution yield of the Alerian MLP Index and the trailing 12-month dividend yield of the S&P 500 Index. As of 4/30/2018. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

In order for a master limited partnership to be exempted from paying federal taxes on its earnings, at least 90% of its income needs to be considered “qualifying income.” Qualifying income can be income and gains from a variety of energy-related activities, like processing, storing, or transporting crude oil and natural gas.3

As the partnership is not paying tax on its income, the tax burden falls to the unitholder. According to the SEC, “limited partners report on their tax returns their share of the MLP’s income, gains, losses, and deductions, and are taxed at their individual tax rates.” 4

However, the tax treatment on MLPs is not always straightforward and investors should be aware of multiple factors:

Schedule K-1. Each year, MLP unitholders receive what is known as a Schedule K-1, an IRS form used to report the unitholder’s share of the partnership’s income, deductions, credits, etc.

Composition of the MLP distributions. Distributions from an MLP don’t necessarily represent the unitholder’s share of the MLP’s income. Many MLPs distribute more to the unitholders than is generated as income, which means that the excess distribution is treated as a return of capital, ultimately lowering the cost basis of the investment. Once the MLP unitholder sells the investment, he or she may be required to recognize both ordinary income and capital gains. As a result, only a small amount of each distribution is considered taxable until the units are actually sold.

Taxes on distributions not received. According to the SEC, MLP unitholders may still need to pay applicable taxes even if the MLP doesn’t provide the unitholder with cash distributions. For example, “if debt owned by an MLP is discharged in a restructuring or bankruptcy, the amount of debt discharged may be treated as income,” meaning investors may owe income taxes despite not receiving a cash distribution.5 A restructuring or bankruptcy is rarely a good thing for investors, but in the case of MLPs it can add an additional headache when it comes to taxes.

State taxes. According to the SEC, investors may need to file state tax returns in states that the MLP operates in, even if the investor doesn’t live in that state.6

MLPs held in retirement accounts. Sometimes an MLP will generate unrelated business taxable income, or UBTI, which could lead to a tax bill even if the MLP is held in a tax-deferred individual retirement account (IRA). While the income earned in a retirement account is generally tax deferred, UBTI may actually be taxed in an IRA. In other words, an investor holding an MLP in a retirement may still owe tax. If an MLP is held in a tax-deferred retirement account, it’s usually up to the MLP unitholder to send the Schedule K-1 to the IRA or retirement account custodian.

Tax consequences of MLP mutual funds or exchange-traded funds. Mutual funds and exchange-traded funds (ETFs) can offer diversification benefits relative to investing directly in the partnerships themselves, but they don’t offer the same tax advantages. If a mutual fund or ETF has more than 25% of its holdings invested in MLPs, it’s subject to the corporate tax rate of 21%. Investors in MLP mutual funds or ETFs would then receive a 1099-DIV each year. While this may simplify the tax return process compared to receiving multiple Schedule K-1s, it adds an additional layer of taxes on the investment and can be a drag on returns.

All of these factors add extra layers to the tax consequences of owning individual MLPs, and we always suggest consulting a tax professional about the potential tax implications before making any investment.

Sector concentration is high

Most MLPs are concentrated in the energy sector due to legislation passed in 1987 that generally restricted the use of the MLP structure to much of the energy industry. Since most MLPs operate in the energy sector, it’s difficult to get much sector diversification—in fact, the Alerian MLP index, one of the most well-known MLP indexes, focuses solely on the energy sector.

And the size of the master limited partnership market is much smaller than the stock market. There are currently only 42 members of the Alerian MLP Index, with a combined market capitalization of just $304 billion, compared to a total market capitalization of over $23 trillion for the S&P 500 Index.7

Given the large share of energy issuers, MLP performance has tended to be correlated to the price of oil over time. Over the past decade, the average rolling 12-month correlation between the Alerian MLP Index and the S&P 500 was 0.54, compared with a 0.51 average correlation between the Alerian MLP Index and the price of oil.8 So when investing in MLPs, the outlook for the price of oil can be just as important as the outlook for the U.S. stock market.

Shown differently, the price of the Alerian MLP index has tended to move in the same direction as the price of oil. For example, the Alerian MLP Index lost 55% from mid-2014 through early 2016 when the price of oil plunged by 76%.9 While rising oil prices could serve as a boon for MLPs, falling oil prices could lead to disappointing returns.

MLP prices tend to track oil prices

Source: Bloomberg and St. Louis Federal Reserve, using weekly data as of 4/27/2018. Alerian MLP

Additional Risks

In addition to sector concentration and the various tax complexities that accompany the MLP structure, there are some other factors that investors should be aware of:

Predictability of distributions. MLPs generally forecast how much they intend to distribute to their limited partners. However, that distribution amount may get reduced, which can negatively impact investors who rely on income payments, like many investors in retirement. And if an MLP reduces its distribution, its price tends to decline as well, meaning investors may be faced with declining income payments and falling principal amounts simultaneously.

Potential conflict of interest between the general partner and the limited partner. Since the general partner (GP) is controlled by the corporation that contributed the assets, the GP may act in a way that benefits itself and the underlying corporation instead of the limited partners. According to the SEC, the GP “may consider its own interests ahead of interests of the MLP and its limited partners and resolve conflicts in a manor favorable to itself.” 10 The GP is also incentivized to increase distributions made to the limited partners so that the GP itself can earn a higher share of those cash flows. General partners receive what is known as an “incentive distribution right,” which is the “general partner’s right to an increasing share of cash distributions as certain cash distribution benchmarks for the limited partners are achieved.” 11 In other words, as the cash distributions made to limited partners rise, the GP earns a greater share of the total cash flows.

Legislative risk. Since the pass-through structure of an MLP offers investors favorable tax treatment, any changes to the tax code could pose a risk to MLPs. With the passage of the Tax Cuts and Jobs Act at the end of 2017, MLPs are still not taxed on their income, but the drop in the corporate tax rate has narrowed the tax advantage between MLPs and traditional corporations.

Portfolio construction: MLPs are not bond substitutes

Master limited partnerships should not be used as “bond proxies,” in our view, or substitutes for core fixed income investments like U.S. Treasuries or other highly rated bonds, mainly due to their elevated volatility. The chart below illustrates that although MLPs have generated higher annualized returns over the past 20 years than both the broad stock market and U.S. Treasuries, those returns have come with higher volatility. The annualized standard deviation of the Alerian MLP index has been almost four times as much as that of the Bloomberg Barclays U.S. Treasury Bond Index.

MLPs have historically delivered higher total returns than stocks and bonds, but with much more volatility

Source: Schwab Center for Financial Research with data from Morningstar Inc. Indexes represented are the Alerian MLP Index, the S&P 500 Index, and the Bloomberg Barclays U.S. Treasury Bond Index. The annualized total return and standard deviation are for a trailing 20-year period, using monthly returns from May 1998 through April 2018. Returns assume reinvestment of bond principal and interest and are not adjusted for taxes. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

Dividends or distributions only account for part of an investment’s return. Price changes account for the other part. If the price of an investment drops by more than the income distribution, then the total return of an investment over a given time horizon can still be negative.

When considering master limited partnerships, don’t just invest based on the high yields they offer, as those high yields come with greater risks. Investments that offer yields above the yields of common stocks and high-quality bonds generally come with higher volatility. And we believe that investments in master limited partnerships should always be considered part of the “equity” allocation of a diversified portfolio, not part of the “bond” allocation.

What to do now

Master limited partnerships can help provide investors with higher income payments than many other investment alternatives, but they also come with higher risks and more complexity. Before investing in MLPs, investors should weigh those risks against the higher distributions offered, and make sure that an allocation to MLPs fits into your risk tolerance. While they have historically delivered high average total returns, the values of MLPs have been volatile over time. And last, consult a tax professional about the implications of investing in master limited partnerships, as owning individual units, and the Schedule K-1 that comes with them, adds an additional layer of complexity come tax time.

1 Source: “An Introduction: Master Limited Partnerships,” Vinson & Elkins. The “sponsor” is the entity, individual or group that forms the MLP and contributes the initial assets to the MLP.2 Securities and Exchange Commission, “Updated Investor Bulletin: Master Limited Partnerships—An Introduction,” November 3, 2017.3 Section 7704 of the Internal Revenue Code of 19874 Securities and Exchange Commission, “Updated Investor Bulletin: Master Limited Partnerships—An Introduction,” November 3, 2017.5Ibid6 Ibid7 Source: Alerian MLP Index fact sheet, as of March 31, 2018 and S&P 500 Index fact sheet, as of April 30, 2018.8 Source: Schwab Center for Financial Research with data from Morningstar. Correlation is a statistical measure of how two investments move in relation to each other. Correlations mentioned represent the average 12-month rolling correlation of monthly total returns from April 2008 through March 2018. Indexes represented above are the Bloomberg Barclays U.S. Treasury Bond Index, S&P 500 Index, and West Texas Intermediate Oil. Past performance is not indicative of future results.9Source: Bloomberg, from 6/20/2014 through 2/11/2016. Generic 1st Crude WTI Contract and the Alerian MLP Total Return Index. 10 Securities and Exchange Commission, “Updated Investor Bulletin: Master Limited Partnerships—An Introduction,” November 3, 2017.11 Fenn, Tim, 2014, “Master Limited Partnerships (MLPs): A General Primer,” Latham & Watkins LLP

What You Can Do Next

Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982,visit a branch or find a consultant.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Performance may be affected by risks associated with non-diversification, including investments in specific sectors. Each individual investor should consider these risks carefully before investing in a particular sector.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships, calculated using a float-adjusted, capitalization-weighted methodology.

The S&P 500 Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity and industry group representation.

Bloomberg Barclays U.S. Treasury Bond Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have $250 million minimum par amount outstanding and at least one year until final maturity. Sub-indices based on maturity such as the U.S. 1-5 Year Treasury and the U.S. 5-10 year Treasury Bond Indices are inclusive of lower bounds. U.S. Intermediate Treasury includes bonds with maturities of 1 to 9.9999 years. U.S. Long Treasury includes maturities 10 years and greater.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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